Revenue

Hey (Hey), You (You), Stop Taxing My Cloud

Jim McGeever, the chief operating officer of NetSuite (N), thought his financial management software company was going out of its way to collect the right amount of sales tax from customers who purchase its products online. If anything, he says, he was too careful. The San Mateo (Calif.)-based firm paid tax consultants $50,000 to make sure it was following the law and wound up taxing customers for Internet sales in states where its competitors didn’t, even though that put the company at a competitive disadvantage.

Texas wasn’t impressed. Officials called to complain that NetSuite had failed to collect on sales in the state. The resulting dispute and settlement with the state illustrate the growing clash between a tax system built to handle real-world exchanges of tangible goods and an Internet marketplace that exists everywhere and nowhere and whose products take the form of invisible ones and zeroes. “It is an enormous burden on businesses trying to figure this all out,” McGeever says.

The problem arises because cloud computing often transforms taxable goods into nontaxable services. Companies that once installed racks of servers in their offices and bought software on CDs are replacing them with offsite solutions sold by IBM (IBM), Amazon.com (AMZN), and Google (GOOG), among others. A company in New York can sell space on servers in North Carolina to an Illinois company with offices in Texas and Florida, leaving businesses, customers, and tax collectors to squabble over who should pay what to whom. “The states are dealing with it quite poorly, not because they’re trying to deal with it poorly, but because they’re trying to adapt,” says Reid Okimoto, a senior manager at KPMG.

The confusion over taxing the cloud goes beyond e-commerce fights about whether retailers should have to collect taxes on online purchases. There is general agreement that, say, Pennsylvania can tax Philadelphia residents for books purchased on Barnes & Noble’s (BKS) website, since the company has physical stores in the state. (In practice, of course, many online retailers don’t always collect taxes; they leave it to customers to, in theory, do so on their own.) But when books become bits and deliveries occur with a click, sales tax laws get murky.

If they don’t figure it out, states stand to take a big hit in lost revenue. The global market for cloud computing is expected to rise to $241 billion in 2020 from $40.7 billion this year, according to Forrester Research, which analyzes technology trends. Cautious about writing static rules for a dynamic marketplace, states are largely holding back and waiting to see what happens. “The advent of cloud computing is making it somewhat more urgent because there is more and more of this going on, supplanting, in particular, sales of software,” says Michael Mazerov, a senior fellow at the Center on Budget and Policy Priorities in Washington. Big data companies are taking the opposite approach. Amazon, Apple (AAPL), Verizon Communications (VZ), and other firms are pushing federal legislation that would limit states’ authority to tax digital goods and services.

McGeever says that in trying to follow the law, confusing as it is, NetSuite sometimes gets stuck cleaning up after other firms that don’t. Purchasing a competitor can mean paying between $500,000 and $1.5 million to settle outstanding taxes, which can take more than a year. “It’s expensive in terms of time, it’s expensive in terms of money,” McGeever says. “It’s just … very difficult.”